Yves here. By way of background, “Deals of the Year” are typically ones commemorated by the trade press as being “innovative”. That means at the time they were completed, they have to have had novel features that created the appearance of a win-win, such as allowing a type of entity that had never been able to raise money from investors to obtain financing (presumably at less than a loan shark’s rate).
This post explains that The Bond Buyer celebrated a deal that was a big loser for the borrower, DC Water.
Dan Kaplan gave an intriguing addition to his article below, noting that, “In fairness to Goldman, they were not the instigators of this financing, only the beneficiary of DC Water’s desire to enhance its prestige at the expense of its ratepayers.” In other words, Goldman didn’t engage it its usual practice of finding a muppet to exploit. DC Water showed up at Goldman wearing a sign, “I’ll be your muppet if you figure out how to get me some good press clips” and Goldman was only too happy to oblige.
It also shows more broadly how an investment category we have long viewed skeptically, social impact bonds, are good deals for the intermediaries and often for the investors too, which means that the actual cause would have done better via government financing or charity.
By Dan Kaplan, infrastructure professional. Originally posted on LinkedIn
Memo to Bond Buyer: DC Water “Deal of the Year” is a Deal to Avoid (Unless You Are
Imagine buying a home for $500,000. The probability of severe damage from a storm or fire is small (say 2.5%), but the loss would be significant. Paying an annual premium of $1,000 to insure against these events is good financial sense, unlikely as they may be.
Suppose that you will make $100,000 in mortgage payments over four and a half years and the insurance company offers a policy to reimburse you for 85% of these payments if the home is damaged. The company asks for a premium of $247,000 for this period.
Not a policy that one is likely to buy, is it?
Yet when the DC Water and Sewer Authority wrapped a similar insurance policy around a $25 million bond in late September 2016 and called it an “environmental impact bond” The Bond Buyer awarded Deal of the Year status to the issue, calling it “an innovative, first of its kind and precedent-setting financing…that carries much promise for funding the nation’s environmental infrastructure needs.”
The Bond Buyer’s analysis of the deal was weak. It correctly reported the issue’s 3.43% interest rate and April 1, 2021 mandatory tender date, but concluded that the rate was “comparable on a cost of funds basis to its historic cost.”
While the 3.43% rate was representative of 30-year borrowing costs at the time, The Bond Buyer neglected to report that yields in 2021 that week were only 1.10% to 1.20%. An issue with a mandatory tender in 2021 without DC Water’s innovative structure might have priced at a 1.40% yield on the high side, a full 2% lower than DC Water’s 3.43% interest rate. Add to that DC Water’s re-financing risk in 2021 (will tax-exemption still be there?) and The Bond Buyer’s case for comparability has little merit.
The innovative aspects of the deal center around $3.3 million of risk share payments that might be exchanged between DC Water and its investors. Should DC Water’s green infrastructure project reduce polluting stormwater by less than 18.6%, it would receive $3.3 million from its bondholders on April 1, 2021. That payment that would cover 85% of the interest expense on the bond and reduce its effective rate down to 0.56%. DC Water will pay investors $3.3 million if stormwater runoff is reduced by more than 41.3%, but that would be a positive outcome, as it would signal that millions of dollars of more traditional infrastructure spending to reduce stormwater could be avoided.
The Bond Buyer article goes on to report that according to the CFO of DC Water, the most likely outcome is that no payments will be made by either party.
That should have been a signal for The Bond Buyer to ask more questions. What level of risk were DC Water and its investors assuming at the specified levels of stormwater reduction? What was the likelihood that the project would perform poorly and that DC Water would receive the $3.3 million payment?
DC Water, in fact, did answer these questions in a June 23 board presentation (pages 43 and 44), stating that it would establish a statistical 95% confidence interval for predicted reductions in stormwater runoff. The most likely outcome, at the 95% confidence level, is that stormwater reductions would be between 18.6% and 41.3%, resulting only in the payment of stated interest and principal on the bonds and no exchange of risk share payments. Outflow reductions that would result in payments by either party are events at the tail ends of the confidence interval, each having an expected probability of only 2.5%.
The 2% interest rate premium and the low probability of receiving a payment are compelling reasons for issuers to avoid this type of financing. The 3.46% rate means that DC Water will be paying its bondholders $2.3 million of additional interest to insure itself against the risk that its green infrastructure will underperform (compared to interest costs on an “uninsured” offering at a rate of 1.40%). That is a steep premium for an event that has only a 2.5% probability of occurring and a payoff of $3.3 million.
And for assuming that small level of risk, Goldman Sachs, the primary investor, found a way to earn 2% (tax-exempt) above the market for holding Aa2/AA+ parity debt of DC Water.
The Bond Buyer is the newspaper of record for the municipal bond market. Awarding “Deal of the Year” status to an issue carries an obligation to thoroughly and thoughtfully examine its merits and costs. The Bond Buyer’s reporting of DC Water’s environmental impact bond fell short of this standard. The next time The Bond Buyer recommends a promising way for funding the nation’s infrastructure needs, let us hope that it will be more diligent in its reporting.
In a Governing Magazine article , DC Water said that it took “two years to iron out” the deal. It received technical assistance from the Harvard Kennedy School Government Performance Lab and grant funding from the federal Office of Social Innovation. DC Water and its advisors may have created an innovative financing but seem to have forgotten that its customers are the ones who will be paying $2.3 million of additional interest for the most likely outcome of this experiment.
Innovation in the public sector should strive to “do more with less.” It is difficult to see how DC Water accomplished this with its environmental impact bond. Other utilities would do well for their ratepayers to avoid this type of financing for their capital programs.